Part 4: The early operation of the Luggate joint venture

Inquiry into property investments by Delta Utility Services Limited at Luggate and Jacks Point.

In this Part, we outline how the joint venture operated and its financial arrangements. We discuss:

  • the contracting work for Delta;
  • the financial arrangements for the joint venture;
  • how Delta funded its contribution;
  • funding the developments costs for the joint venture; and
  • the governance and management of the joint venture.

We then make some overall comments about the early operation of the Luggate joint venture.

Summary of our findings

Delta had priority for contracting work at the site and expected to make a profit of about $1 million from doing this work for the joint venture. Both Delta and Aurora Energy Limited did some work at Luggate Park and were paid for that work. However, because the development did not proceed as planned, Delta did not get the revenue or profit from the work that it expected.

The structure of the joint venture and related financial arrangements were reasonably complex, and were influenced by tax considerations. The arrangements were based on success and did not address what would happen if the sections did not sell as planned. There was not enough focus on the risks or the exit strategy.

The joint venture parties borrowed the costs of the development work at Luggate Park from a bank. They increased the amount borrowed from time to time. However, they became reluctant to borrow more because of the lack of demand for the Luggate Park lots. Had the parties borrowed more, the final loss would have been greater.

In our view, the parties were prudent in putting the development on hold and containing costs while waiting for the market to improve. The governance and project management arrangements operated effectively for a venture of this kind. However, aspects of Newtons' involvement in the Luggate transaction did not meet the accountability requirements of the Local Government Act.

Delta directors agreed to a request from Luggate Holdings Limited to use the joint venture land as security to raise funds for unrelated purposes, after negotiating an arrangement that did not weaken Delta's position.

Contracting work for Delta Utility Services Limited

The joint venture agreement provided that Delta would get priority for physical contracting work in the Luggate Park property development. There was a process for testing Delta's pricing if the joint venture thought that necessary.

In seeking the Delta board's approval for the joint venture, the value of the contracting work was estimated to be $5.3 million. Part of the appeal for Delta was that it considered this work would have a better profit margin than most of its other work. Delta expected to make a profit of about $1 million. We were told that work at Luggate Park did not involve some of the seasonal problems associated with other locations, so the work could continue year-round.

Delta had done work for Luggate Holdings Limited during stage 1 of the Luggate Park development and on some other developments that Mr Boult was involved with.39

The joint venture development did not proceed as planned because of the market slowdown, so revenue that Delta earned for the work and any corresponding profit was less than estimated.

Delta gave us information showing that the combined revenue from work by Delta and Aurora Energy Limited at Luggate Park from 1 January 2008 was $1.415 million (including $160,000 of maintenance and remedial works). The joint venture paid Delta and Aurora Energy Limited for this work. The joint venture funded these payments from the loan from the bank for development costs.

Financial arrangements for the joint venture

The initial proposal was that the parties would form a joint venture company to carry out the development. However, in August 2006, near the start of discussions, Mr Boult said, after a discussion with Luggate Holdings Limited's legal and tax advisors, "to avoid a significant tax issue from our end, we would like to suggest a different way of structuring this". The different structure proposed at that time was essentially the joint venture structure that was later agreed.

Delta managers noted that the proposed structure offered a "tax timing benefit for Luggate", which should be reflected in the price. Delta managers told Mr Boult that they would seek the views of the joint venture subcommittee. They cautioned that the directors might not have an appetite for a more complex structure. However, a few days later, managers told Mr Boult that the proposal was generally acceptable to Delta's directors.

In March 2007, when they were negotiating the terms of the joint venture agreement, the legal advisor for Luggate Holdings Limited made the company's position clear to Delta's legal advisor, saying:

My understanding of the proposal is for the land to be held by a custodian company as a ‘bare trustee' …. It is not my understanding that the land would be sold to that company as this destroys the structure that has been carefully agreed between the parties for the purposes of entering into the joint venture. Luggate cannot proceed with the proposal if the terms of the agreement provide for the land to be sold outside the Luggate group immediately as that will give rise to an immediate tax liability that will be payable on the realisation of the land and there would be no cash flow to support the payment of tax.

To achieve the outcome sought the joint venture agreement provided that Luggate Holdings Limited would provide the land to the joint venture by advancing half of the agreed land value to Luggate Properties Limited, and Delta (through Newtons) would lend Luggate Properties Limited its half of the agreed value of the land in cash. This meant that each party's investment in the venture would be equal. It also meant that the land would be transferred to the joint venture for the development without a sale taking place. We understand that such a structure is not unusual for bringing a partner into a property joint venture.

Luggate Properties Limited had to use the money that Newtons advanced to discharge any mortgages over the land. This was so the land would be unencumbered and could be mortgaged in keeping with the joint venture agreement.

The advance from Newtons was subject to a deed of acknowledgement of debt between Luggate Properties Limited, Newtons, and Luggate Nominee Limited (entered into on 14 May 2008). Under this deed, Luggate Nominee Limited agreed to grant a mortgage over the land to Newtons to secure repayment by Luggate Properties Limited of the advance from Newtons. The advance of Luggate Holdings Limited's share of the value of the land to Luggate Properties Limited was unsecured.40 However, it was also covered by a deed of acknowledgment of debt.

The contributions of both joint venture parties, representing half each of the agreed land value of $10.7 million, were to be repaid from subsequent sales. The joint venture agreement provided that, each time a section was sold, the parties would each receive half of the:

  • unimproved value of the section41 – this would repay their advances of cash (Newtons) and land (Luggate Holdings Limited); and
  • value of the improvements (the infrastructure services that would be provided for each lot).

If the land value increased, the parties would also share any surplus after expenses had been met.

How Delta Utility Services Limited funded its contribution

Delta funded its share of the joint venture by borrowing $5.35 million from Dunedin City Treasury Limited to acquire shares in Newtons.42

The Newtons board met for the first time on 22 April 2008. Mr Polson was appointed as chairman and to represent Newtons and Delta on the board of Luggate Nominee Limited. Delta appointed Mr Liddell and Dr Evans as the other directors of Newtons.

The Newtons directors resolved on 30 April 2008 to issue 5,350,000 shares to Delta Utility Services Limited for $1 for each share ($5.35 million).

Dunedin City Treasury Limited advanced these funds to Delta for payment to Newtons. Newtons then advanced the funds to Luggate Properties Limited as an interest-free loan on 17 July 2008. This was the settlement date for the transaction, which was slightly later than planned.

After resolving to issue shares to Delta and advancing the loan funds to the joint venture, the Newtons board did not meet again until July 2009. Newtons was not actively involved in governing the joint venture in that initial period (April 2008 to July 2009). At that time, it was merely the means to lend funds to the joint venture.

Newtons became more actively involved in governing the joint venture from mid-2009, after it acquired the Jacks Point land.

Funding the development costs for the joint venture

The joint venture partners had agreed to borrow from a bank to fund the development costs of stage 2 of the Luggate subdivision. Each party was liable for half the amount owing. Repayment of this debt to the bank would be secured by a mortgage over the joint venture land.

In July 2008, the joint venture entered into a loan agreement with a bank to borrow up to $500,000 to fund the initial development costs for the venture, for a term of 12 months, with an ability to capitalise interest costs up to a maximum of $45,000. The bank required a first mortgage over the land in return for the loan.

During the period of the Luggate joint venture project, the bank loan was increased several times to meet the joint venture costs, such as buying a section and building a house on it to sell as a package, and necessary upgrades to the sewerage treatment system and the costs of undergrounding overhead power lines.

The joint venture did not make interest payments, so the interest costs were capitalised (added to the principal).

The bank's funding had priority for repayment over Newtons' advance

The joint venture parties entered into a deed of priority with the bank to agree that the bank's development funding would have priority for repayment over the contributions of the joint venture partners.

The deed of priority was amended each time the bank loan was increased to increase the "priority amount" of the bank's lending over the contributions of the joint venture partners.

The bank's priority amount had increased to $1.935 million by August 2010.

The effect of the arrangement with the bank was that Newtons' mortgage had second priority to the bank's mortgage. As sections were sold, Newtons and Luggate Properties Limited would be repaid after the bank debt had been paid.

In mid-2009, at Mr Boult's request and with Newtons agreement, after several months of negotiations and legal advice, a third mortgage was granted over the joint venture land. The third mortgage secured Luggate Holdings Limited's $5.35 million contribution of land to the joint venture.43 It was to be used as a collateral security for business ventures unrelated to the joint venture.

Newtons directors were not keen on the third mortgage arrangement in the form first proposed because they considered it weakened their security. They were also concerned that the proposed lender (a finance company) could get rights over the joint venture land, including the right to sell it if there was a repayment default. However, Mr Boult had said in early 200844 that the Luggate companies would seek an arrangement of this kind, so the directors considered that they needed to find a way to make it work.

The directors eventually agreed to a restructured proposal, involving a third mortgage over the joint venture land granted by Luggate Nominee Limited to Luggate Holdings Limited, which then submortgaged it to the same bank that had lent the joint venture the development funds. The submortgage was a collateral security for obligations of another company related to Luggate Holdings Limited but not involved in the joint venture.

The Newtons directors saw this arrangement with the bank as preferable to the proposed involvement of the finance company. They had legal advice that the restructured arrangement would not give the bank the right to sell the joint venture land if the other company that was not involved in the joint venture defaulted.

The effect of the arrangement was that the new third-ranking mortgage had the same priority for repayment as Newtons' loan under its second-ranking mortgage. This was because the joint venture agreement provided that the joint venture partners would get an equal share of the land value of each lot from the proceeds when any lot was sold. This overrode the rankings of the security interests of the parties. The deed of priority of securities reflected this. It recorded the nominated amounts held by the security holders and their rankings as:

  • first security holder (bank) – $1.545 million (in August 2010, this was increased to $1.935 million);
  • second security holder (Newtons) – $5.5 million; and
  • third security holder (Luggate Holdings Limited) – $5.5 million.45

As it turned out, the relative priorities of the second and third mortgages were not relevant because of the lack of sales.

The negotiations over the arrangement further illustrate the robust commercial relationship between the joint venture partners, and also Delta's efforts to maintain a good working relationship in the interests of the success of the joint venture.

Governance and management

Under the joint venture agreement, the parties agreed to form an owner board to govern the joint venture. Luggate Properties Limited had the right to appoint up to three members, and Newtons had the right to appoint up to two members. Luggate Properties Limited never exercised its right to have one extra member on the owner board. As noted in paragraph 3.138, it told Delta early in the negotiations that it would not do so.

Mr Boult and Mr Macdonald represented Luggate Properties Limited on the owner board. Newtons' representatives were Mr Polson and Mr Liddell.46 Mr Polson was appointed chairman of the owner board.

The owner board first met in April 2008, then regularly until the end of March 2009. In March 2009, the Luggate Park development was put on hold because of market inactivity.

The owner board was responsible for preparing policies and procedures for managing the development and considering the annual budget. It had to approve all joint venture expenses.

Managing the joint venture

The joint venture agreement required the parties to enter into a management agreement with Armada Holdings Limited (Armada) as the management company for the venture. Armada, based in Queenstown, was owned by Mr Boult and his family.

The parties entered into the management agreement in early 2008. Armada's responsibilities included preparing an annual budget and annual financial statements, and regular reports to the owner board. Mr Boult acted as the project manager for an agreed monthly fee of $5,000, and an Armada staff member provided administrative support. Armada was also able to recover its costs for providing administrative and management services from the joint venture.

The joint venture agreement did not require the joint venture's financial statements to be audited, but Delta could require its auditor to audit them at its expense.47

The joint venture did not pay Delta for time that Delta staff spent on the Luggate project.

Luggate Holdings Limited had hired a company, Signal Management Group Limited (Signal), to help with stage 2 of the development, including offering advice on development costs for each stage and related matters. Signal wrote a series of reports on the project from January 2008 to February 2010.

It was agreed that the owner board would manage the project, but a project co-ordination group of Mr Boult, Signal, and a Delta staff member would talk about operational matters weekly.

The state of the market in the middle of 2008

At the owner board's first meeting in April 2008, Mr Boult proposed initially developing 43 of the stage 2A lots, rather than all 138 lots. The stage 2A land was separated by Dead Horse Creek. The 43 lots on the west side of Dead Horse Creek were referred to as stage 2A1 of the development.

In a report to the owner board for its August 2008 meeting, Mr Boult set out the sales that would be needed to justify starting the 43 stage 2A1 lots. Mr Boult noted that the property market was "less than buoyant". At that time, the owner board planned to start developing stage 2A1 in December 2008.

Signal prepared a concept plan for developing the 43 stage 2A1 lots. It began estimating the development costs of those lots. Delta had the first right to do this work.

Signal estimated that the development costs of the stage 2A1 lots would be about $102,000 for each lot. This was about $40,000 more than the estimates from when the parties entered into the joint venture. Mr Boult suggested that this was partly because of Delta's pricing and that it was difficult not being able to go to the market to test that pricing. Also, stage 2A had a significant amount of "front end" costs involving storm water and the sewage treatment plant that were actually for the whole development. However, these costs made the development costs for the stage 2A lots higher than they would be for the rest of stage 2.

In October 2008, Mr Boult told the owner board that the property market was in a period of uncertainty and general confusion and that it was unclear how this would pan out. He recommended proceeding with the plan for stage 2A1 and launch to market. If the parties could get 10 pre-sales, they could proceed. However, if they could not, the joint venture would need to reconsider its strategy.

Mr Boult also noted that some property owners in the already developed part of Luggate Park in stage 1A wanted to sell their sections and that this might affect sales of stage 2A1 lots. Mr Boult suggested that the joint venture buy a couple of the stage 1A sections and build houses on them to sell as house-and-land packages. The owner board agreed to buy one of those sections and build a house on it. In December 2008, the bank agreed to extend the joint venture loan to fund this.

In December 2008, the joint venture commissioned some material promoting house-and-land packages at Luggate. Delta asked for its details to be removed from the material, because it preferred to keep its involvement low profile at that time.

Efforts to market and sell residential lots at Luggate Park

Efforts to market the Luggate land in 2008 and 2009 included:

  • entering an agreement with a United Kingdom-based company for it to market the Luggate development in jurisdictions other than New Zealand and Australia for a commission the joint venture paid $10,000 for the costs of a representative from that company to visit New Zealand and also met the costs for Mr Boult to visit the company in the United Kingdom;
  • getting various real estate firms and other marketing experts to advise on strategies to sell lots in stage 2A and receiving regular market updates from those agents and experts;
  • promoting the idea of a dairy/caf business at Luggate township;
  • considering marketing house-and-land packages, rather than just the developed lots, as a way to get sales in a difficult market, and discussing this with suppliers of various housing products, such as pre-designed homes; and
  • building a "spec house" on one of the lots.

Despite these efforts, there were no sales in the period from July 2008,48 the formal start of the joint venture, to April 2010, when the joint venture's "spec house" sold. There were only four further sales at Luggate Park from April 2010 to September 2012. The joint venture did not spend significant amounts on these marketing efforts, apart from travel costs for pursuing the arrangement with the United Kingdom-based company. However, that company did not make any sales.

Deciding to put the project on hold

At the end of March 2009, the owner board discussed the quiet state of the market. It agreed to put the development on hold for six to nine months and to review this in September 2009. The owner board agreed to keep the project running at a bare minimum, by completing work to put the overhead power lines underground, completing a necessary upgrade to the sewage system to comply with discharge consents, and finishing the "spec house" development.

Mr Boult offered to reduce Armada's monthly management fee while the project was on hold to $3,000 a month. Delta offered to take over the project management role from Signal, using the same team that it was using for the Jacks Point project then under way. Signal produced its last report on the project in February 2010.

Luggate Park development remained on hold for the rest of 2009

There was little activity at Luggate Park for the rest of 2009 after the owner board put the development on hold at the end of March 2009.

The most significant development was a favourable decision from the Environment Court on the stage 2B resource consent in October 2009.

Mr Boult had become chief executive of Christchurch International Airport in February 2009 but remained involved in the Luggate project.

The owner board met in November 2009 for the first time since July 2009. At the November meeting, Mr Boult assessed the market as showing a general improvement and recommended re-launching Luggate Park with a new campaign focused on affordable house-and-land packages. The owner board also considered marketing the high-end lots on the elevated plateau (stage 2B) now that resource consent had been granted.

The Luggate market was "dead" when Delta decided to buy into Jacks Point

On 1 April 2009, when advising the Delta board of the decision to put Luggate Park on hold for six months, Mr Polson described the Luggate market as "dead". At the time, Delta was considering buying into the Jacks Point property development.

Our comments on how the joint venture operated

The project to develop and sell residential sections at Luggate Park never progressed as planned because of a lack of market interest, which those involved attribute to the global economic crisis and its effect on the property market in Central Otago.

There is no doubt that the economic situation affected the success of the venture. Part of the business proposition for Luggate Park was that it would meet a need for affordable land for housing in a reasonable location near Wanaka. This should have met a need for such land in the Queenstown Lakes District Council area and is consistent with government policy to encourage affordable housing. However, the Luggate site did not appeal to purchasers as hoped, and demand for affordable land for housing in the area was not as strong as the parties expected.

Having realised soon after they entered into the joint venture that the market was slower than expected, the parties proceeded cautiously. They first planned to progress part of stage 2A only (stage 2A1) and then only if they could get enough pre-sales to justify starting construction. However, the pre-sales did not take place and the development costs were considerably higher than forecast, so this made even stage 2A1 uneconomic.

The parties considered other options to generate sales, and got marketing advice from various real estate firms. None of the strategies employed were successful.

The market did not improve, but the parties were cautious and contained costs to the minimum necessary rather than putting more money in. The loss would have been greater if they had continued to spend money developing the land in the absence of market interest.

The value of the contracting work to Delta and corresponding profit was far less than estimated, but the development was never going to be large enough to be a major source of profit for Delta from construction work. The value of the construction work was not a major consideration for Delta entering into the project.

The joint venture parties borrowed from the bank for some development costs, including for necessary upgrade work to the sewerage treatment plant and undergrounding of overhead power lines, and also to buy a section and build a house on it as a way of generating sales. They increased the amount borrowed from time to time, and did not make any interest payments, so interest costs were capitalised.

The parties reached a point where they were reluctant to borrow further from the bank because of the lack of demand. Had they borrowed more, the final loss would have been greater. In our view, the parties were prudent in putting the development on hold and containing costs while waiting for the market to improve.

Funding arrangements

Delta received tax advice that an unincorporated joint venture was an appropriate legal structure for the Luggate development because it would enable the parties to access any tax losses. Delta also received tax advice on other aspects of the transaction and potential effects on Delta and the holding company group. It is appropriate for a public entity to carefully consider the tax effects of its activities, and Delta did so.

When Delta entered into the Luggate joint venture, it had a first-ranking mortgage to secure repayment of the advance from Newtons of $5.35 million. The parties agreed that the joint venture land had a value of $10.7 million as a development site. If the development had progressed and lots had been sold, there would have been plenty of cover for repayment of Delta's advance. However, the value of Delta's security decreased each time the joint venture borrowed more from the bank because the bank had priority for repayment. Also, under the joint venture agreement, Delta's advance:

  • was repayable only when the sections were sold;49 and
  • ended up with the same priority for repayment as the additional funds that Luggate Holdings Limited borrowed for other purposes during the term of the joint venture.

The funding arrangements were based on success and did not address what would happen in the event of market failure. The arrangements would have worked if the land had been developed and the sections sold at the expected prices, but there was too much focus on the possibilities that the joint venture offered and not enough on the risks or the exit strategy.

Delta directors agreed to Luggate Holdings Limited using the joint venture land as security to raise funds for a purpose unrelated to the joint venture, but negotiated a way of doing this that did not weaken Delta's security or position. We see those negotiations as further evidence of the robust commercial relationship between the parties, and also of Delta's efforts to make the joint venture relationship work.

Governance and management

The governance and project management arrangements operated effectively for a venture of this kind.

The owner board met regularly until the venture was put on hold, and then as required, and received good support from staff from Armada and Delta. The board also received detailed reporting and advice from Signal to inform important decisions, such as whether to proceed with stage 2A bearing in mind the higher than estimated development costs. Mr Boult also provided a report to each owner board meeting on significant activities and strategy. The owner board provided active oversight and financial management. Each representative brought expertise to the project and took an appropriately strategic (rather than managerial) role.

Local Government Act requirements and Newtons

Delta used Newtons to fund the Luggate transaction. To give effect to the joint venture arrangement, the directors of Newtons resolved to issue shares to Delta in return for $5.35 million and later advanced those funds to Luggate Properties Limited.

Newtons did not have a statement of intent in place when the directors made these decisions, and Delta's statement of intent did not cover the activities of subsidiaries. This means that Newtons' involvement in the Luggate transaction did not meet the requirements of the Local Government Act.50

Newtons also made decisions about the Jacks Point investment in 2009 that were not covered by a statement of intent.

39: Delta gave us information showing that the revenue from work by Delta and Aurora Energy Limited on stage 1 of Luggate Park before December 2007 (the date the Delta board agreed to enter into the joint venture for stage 2) was $5.5 million.

40: This changed in mid-2009, as outlined later in this Part.

41: Being the proportionate value of the section sold to the overall value of the joint venture land.

42: The chief executive of the holding company told us that Delta did not go to Dunedin City Treasury Limited for each project. Instead, it would add any expected projects into Delta's annual budget and submit that budget to the Dunedin City Treasury Limited board as justification for an annual borrowing limit. Dunedin City Treasury Limited would not ask for information on particular projects that had already been agreed by the subsidiary and the holding company.

43: When the parties entered into the joint venture, they agreed that repayment of the Newtons advance of $5.35 million would be secured by a mortgage, but repayment of Luggate Holdings' contribution of $5.35 million in land value would not be.

44: During the discussions about funding referred to in paragraphs 3.104 to 3.111.

45: As with the contribution from Newtons, this nominated amount was slightly more than the actual contribution.

46: Until mid-2009, when Mr Coburn replaced Mr Liddell as Delta's representative.

47: In practice, Audit New Zealand has considered the joint venture financial statements during the annual financial audits of Newtons and Delta.

48: There was one sale just before this, and the parties split the proceeds.

49: In 2011, Delta described the advance as more in the nature of "quasi equity" in advice to directors on whether the value of the investment should be treated as impaired at that time.

50: The Local Government Act 2002 states that decisions must be made by or under the authority of the board of the council-controlled organisation, and in keeping with the statement of intent (and, for a company, with its constitution).

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